Cost Classification and Cost Behavior

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Cost Classification and Cost Behavior

• EMBA 5403
• Fall 2008
• Mugan

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Types of Costs

• differential costs- (benefits) costs or
  benefits that change between/among alternatives
• Irrelevant costs -Costs that dont change are
  irrelevant to the decision
• Choose the alternatives where differential
  benefits exceed differential costs
• Opportunity costs
• Sunk costs
• Controllable /avoidable costs/discretionary costs

Costs that have already been incurred and cannot
be changed no matter what action is taken in the
future.
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Problems in Identifying and Measuring Benefits
How do I measure the benefit of employee training?
How do I measure the benefit of improved quality?
What is the monetary benefit of a happy customer?
What is the monetary benefit of an improved
working environment?
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Problems in Identifying and Measuring Costs
What is the cost of a dissatisfied customer?
How do I measure the cost of poor quality?
How do I measure the cost of setting my price too
high?
What is the cost of postponing this years
training program?
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Classifications of Costs

• Behavior how costs react to changes in
  underlying cost driver
• Variable or Fixed
• Function related to production or sales
• Product or Period
• Product costs
• Direct Material
• Direct Labor
• Factory Overhead
• Traceability (cost of tracing cost to a cost
  driver directly should be lower than the benefits.

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Non-manufacturing Costs
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Product Costs Versus Period Costs

• Period costs include all marketing or selling
  costs and administrative costs.

• Product costs include direct materials, direct
  labor, and manufacturing overhead.

Inventory
Cost of Good Sold
Expense
Sale
IncomeStatement
IncomeStatement
BalanceSheet
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Product Cost Flows
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Product Cost Flows
Prime Costs
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Product Cost Flows
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Product Cost Flows
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Product Cost Flows
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Manufacturing Cost Flows
Income StatementExpenses
Balance
Sheet Costs
Inventories
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Graphical Analysis of Activity Costs and Rate of
Output
Curvilinear Total Cost Curve
Marginal Costs are the costs to produce one more
additional unit of outputslope.
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Relevant Range
The relevant range is the portion of the
curvilinear total cost curve that appears in the
normal operations area.
Relevant Range

TotalCost
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The Linearity Assumption and the Relevant Range
EconomistsCurvilinear Cost Function
Total Cost
Activity
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Cost Classifications for Predicting Cost Behavior

• By reaction to changes in the level of
  activity within the relevant range.
• Total variable costs change when activity
  changes.
• Total fixed costs remain unchanged when activity
  changes.

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Cost Classifications for Predicting Cost Behavior
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Extent of Variable Costs
The proportion of variable costs differs across
organizations. For example . . .
A manufacturing companywill often have
manyvariable costs.
A public utility withlarge investments
inequipment will tendto have fewervariable
costs.
A merchandising companyusually will have a
high proportion of variable costs like cost of
sales.
A service companywill normally have a
high proportion of variable costs.
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Examples of Variable Costs

• Merchandising companies cost of goods sold.
• Manufacturing companies direct materials,
  direct labor, and variable overhead.
• Merchandising and manufacturing companies
  commissions, shipping costs, and clerical costs
  such as invoicing.
• Service companies supplies, travel, and clerical

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Types of Fixed Costs
Discretionary May be altered in the short-term by
current managerial decisions
Committed Long-term, cannot be significantly
reduced in the short term.
Examples Depreciation on Equipment and Real
Estate Taxes
Examples Advertising and Research and Development
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Mixed Costs
Activity (minutes)
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Mixed Costs
Total mixed cost
Total Mobile Phone Cost
Variable Cost per minute
Fixed MonthlyPhone Charge
Activity (minutes)
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The Scattergraph Method
Plot the data points on a graph (total cost vs.
activity).
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The Scattergraph Method
Draw a line through the data points with about
anequal numbers of points above and below the
line.
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The Scattergraph Method
Use one data point to estimate the total level of
activity and the total cost.
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The Scattergraph Method
Make a quick estimate of variable cost per unit
and determine the cost equation.
Y TL10 TL1.25X
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The High-Low Method

• Assume the following hours of maintenance work
  and the total maintenance costs for six months.

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Product Cost Estimation Technique
Classification and Methodology Review Niazi.
Dai1. Balabani. Seneviratne Journal of
Manufacturing Science and Engineering MAY 2006,
Vol. 128,563-575
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Product Cost Estimation Technique
Classification and Methodology Review Niazi.
Dai1. Balabani. Seneviratne Journal of
Manufacturing Science and Engineering MAY 2006,
Vol. 128,563-575
32
Product Cost Estimation Technique
Classification and Methodology Review Niazi.
Dai1. Balabani. Seneviratne Journal of
Manufacturing Science and Engineering MAY 2006,
Vol. 128,563-575
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Assigning Costs to Cost Objects

• Direct costs
• Costs that can beeasily and conveniently traced
  to a unit of product or other cost object.
• Examples direct material and direct labor

• Indirect costs
• Costs that cannot be easily and conveniently
  traced to a unit of product or other cost object.
  
• Example manufacturing overhead

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Cost Classifications for Decision Making

• Every decision involves a choice between at least
  two alternatives.
• Only those costs and benefits that differ between
  alternatives are relevant in a decision. All
  other costs and benefits can and should be
  ignored.

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Differential Costs and Revenues

• Costs and revenues that differ among
  alternatives.

Example You have a job paying TL 1,500 per
month in your hometown. You have a job offer in
a neighboring city that pays TL 2,000 per month.
The commuting cost to the city is TL 300 per
month.
Differential revenue is TL2,000 TL1,500
TL500
Differential cost is TL 300
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Opportunity Costs

• The potential benefit that is given up when
  one alternative is selected over another.

Example If you were not attending this program,
you could save TL 10,000 per year. Your
opportunity cost?
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Sunk Costs

• Sunk costs have already been incurred and cannot
  be changed now or in the future. They should be
  ignored when making decisions.

Example You bought an automobile that cost
TL10,000 two years ago. The TL10,000 cost is
sunk because whether you drive it, park it, trade
it, or sell it, you cannot change the TL10,000
cost.
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Summary of the Types of Cost Classifications

• Financial reporting
• Predicting cost behavior
• Assigning costs to cost objects- products-
  determining unit costs
• Decision making

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The Contribution Format
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Idle Time
Machine Breakdowns
Material Shortages
Power Failures
The labor costs incurred during idle time are
ordinarily treated as manufacturing overhead.
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Overtime
The overtime premiums for all factory workers are
usually considered to be part of manufacturing
overhead.
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Unit Costs

• Direct Material- determined as actual usage of
  materials or by engineering estimates (standard
  costs)
• Direct Labor- determined as actual usage of
  materials or by engineering estimates (standard
  costs)
• MOVH common production costs assigned to each
  unit
• Traditional
• ABC
• Unit cost DM DL MOVH per unit

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Labor Fringe Benefits
Fringe benefits include employer paid costs for
insurance programs, retirement plans,
supplemental unemployment programs, Social
Security, Medicare, workers compensation and
unemployment taxes.
Some companies include all of these costs in
manufacturing overhead.
Other companies treat fringe benefit expenses of
direct laborers as additional direct labor costs.
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How to allocate indirect costs to products MOVH

• Depends on the nature of products and production
  system
• Traditional- direct labor hours (DLH) number of
  units produced
• Automation and computer technology have increased
  the indirect costs in many organizations
• Activity-Based Costing (ABC)- a procedure that
  attempts to provide a more precise indirect cost
  allocation

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Numerical Example- Unit Cost

• THD Company produces 4,000 units of Product A and
  20,000 units of Product B each year.
• Direct Material for Product A is TL 10 Product B
  15
• Total indirect product costs are TL 900,000, and
  total direct labor hours(DLH) are 50,000.
• Product A requires 2.5 DLH and Product B requires
  2.0 DLH to produce.
• Direct labor cost per hour TL 30

Continue
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Numerical Example
Management at THD believes that indirect
costs are actually caused by the following five
activities
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Unit Cost - Traditional

• THD uses DLH as the basis
• 1.determine the allocation of MOVH per unit
  predetermined overhead rate(PDOR) PDOR Total
  Overhead/ Total DLH
• 2. determine MOVH per unit PDOR x DL Cost per
  hour
• 3. add DM,DL and MOVH per unit

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PDOR and MOVH
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Unit Costs Traditional
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Numerical Example-MOVH by ABC
The following activity data was supplied by the
management of THD
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Numerical Example-MOVH by ABC
This activity data can be used to develop
application rates for each of the five activities.
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Numerical Example-MOVH by ABC
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Numerical Example-MOVH by ABC
Now that we have calculated the application
rates, we use the rates to assign indirect costs
to Product A.
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Numerical Example-MOVH by ABC
Now that we have calculated the application
rates, we use the rates to assign indirect costs
to Product A.
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Numerical Example-MOVH by ABC
MOVH costs for a unit of Product B
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Reconciliation check
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Unit Costs Using ABC
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Comparison of Unit Costs
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Advantages of ABC
Activity-based costing is very useful in firms .
. .
With multiple products and services.
That have products and services that use indirect
activities in different ways.
That have a high percentage of indirect product
costs.
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Problems With ABC
Proper identification of cost drivers
is difficult.
ABC ignores the difference between the
fixed and variable costs of an activity.
ABC is more costly because additional
measurements and observations must be made.
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Quality of Conformance
When the overwhelming majority of products
produced conform to design specifications and are
free from defects.
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Prevention and Appraisal Costs
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Internal and External Failure Costs
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Examples of Quality Costs

• Prevention Costs
• Quality training
• Quality circles
• Statistical process
• control activities

• Appraisal Costs
• Testing inspecting
• incoming materials
• Final product testing
• Depreciation of testing
• equipment

• Internal Failure Costs
• Scrap
• Spoilage
• Rework

• External Failure Costs
• Cost of field servicing
• handling complaints
• Warranty repairs
• Lost sales

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Distribution of Quality Costs
When quality of conformance is low, total quality
cost is high and consists mostly of internal and
external failure.
Companies can reduce their total quality cost by
focusing on prevention and appraisal. The cost
savings from reduced defects usually swamps the
costs of the additional prevention and appraisal
efforts.
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Quality cost reports provide an estimate of the
financial consequences of the companys current
defect rate.
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Quality Cost Reports Graphic Form
Quality reports can also be prepared in graphic
form.
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Product Life Cycle
http//www.hss.caltech.edu/mcafee/Classes/BEM106/
PDF/ProductLifeCycle.pdf
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http//www.hss.caltech.edu/mcafee/Classes/BEM106/
PDF/ProductLifeCycle.pdf
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Introduction Growth Maturity Decline
http//www.hss.caltech.edu/mcafee/Classes/BEM106/
PDF/ProductLifeCycle.pdf
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http//www.ee.unb.ca/powereng/courses/EE2703/EE270
3_DetailedDesign2.pdf
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http//www.ee.unb.ca/powereng/courses/EE2703/EE270
3_DetailedDesign2.pdf
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Uses of Quality Cost Information
Help managers see the financial significance of
defects.
Help managers identify the relative importance of
the quality problems.
Help managers see whether their quality costs are
poorly distributed.
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ISO 9000 Standards
ISO 9000 standards have become an international
measure of quality. To become ISO 9000
certified, a company must demonstrate

• A quality control system is in use, and the
  system clearly defines an expected level of
  quality.
• The system is fully operational and is backed up
  with detailed documentation of quality control
  procedures.
• The intended level of quality is being achieved
  on a sustained basis.

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Appendix
Least-Squares Regression Using Microsoft Excel.
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Simple Regression Analysis Example
Matrix, Inc. wants to know its average fixed cost
and variable cost per unit. Using the data to
the right, lets see how to do a regression using
Microsoft Excel.
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Simple Regression Using Excel

• You will need three pieces of information from
  your regression analysis
• Estimated Variable Cost per Unit (line slope)
• Estimated Fixed Costs (line intercept)
• Goodness of fit, or R2

To get these three pieces information we will
need to use three different Excel
functions. LINEST, INTERCEPT, RSQ
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Simple Regression Using Excel
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Simple Regression Using Excel
Scroll down to the Statistical, functions. Now
scroll down the statistical functions until you
highlight LINEST
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Simple Regression Using Excel
1. In the Known_ys box enter C4C19 for the
range. 2. In the Known_xs box enter D4D19 for
the range.
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Simple Regression Using Excel
1. In the Known_ys box enter C4C19 for the
range. 2. In the Known_xs box enter D4D19 for
the range.
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Simple Regression Using Excel
With you cursor in cell F5, press the key and
go to the pull down menu for special functions.
Select Statistical and scroll down to highlight
the INTERCEPT function.
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Simple Regression Using Excel
1. In the Known_ys box enter C4C19 for the
range. 2. In the Known_xs box enter D4D19 for
the range.
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Simple Regression Using Excel
Finally, we will determine the goodness of fit,
or R2, by using the RSQ function.
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Simple Regression Using Excel
1. In the Known_ys box enter C4C19 for the
range. 2. In the Known_xs box enter D4D19 for
the range.